Good Investing Talks - What do all successful investments share, Thatcher Martin of Spree Capital?

Episode Date: October 20, 2021

Martin of Spree Capital Advisers has built an investment firm that focuses on the long-term and invests in high-quality businesses. We discussed the eight commonalities of high-quality businesses and his investment in the eBay stock and the Upwork stock.

Hello, today it's a great day because I have Fetra-Marting of Spree Capital on. And as a German, I'm naturally curious why you've chosen the name Spre Capital. I did think about a bit of a crazy theory. Let me try if this might be true, but or I'm curious to hear explanation as well. So you're a Rammstein fan, but you didn't dare to take a name of Rammstein for your firm. So you were thinking about the city where the band comes from. from and that's Berlin and there's the river Spree. Does it have something to do with the name Spray capital or I'm totally wrong? No, sadly no. The name comes from my grandfather had a boat

named Spray and he really had two loves in his life. It was his family in the ocean. And, you know, when you're raising a family, your finances are constrained. So he had to, an opportunity to buy a boat that had been badly damaged by a fire under the stewardship of the previous owner. So he bought it and, you know, spent years restoring it by hand. And I thought that was a great allegory for what I'm trying to do, which is, you know, find assets that are high quality, undervalued, misunderstood. And, you know, with some kind of tailwind, they can provide a lifetime of value. So sadly, it's not related to the German. River, but, you know, it's something special to me.

Is this both still existing? Not. He's since gone up, so no. That's sad. But it's a fascinating story. When I came about, like, studying your materials and your website, I was a bit fascinated because it felt a bit like that the way you present yourself with the website, it's super minimalistic.

You have some sentences there, some bullet points, and longer reports on different companies. And it shows like these reports of the companies show hard work and deep work. Does this two categories, minimalisms and hard work describe you? Sure, I think so. In terms of the minimalism of the website, it's a landing page and I feel like I do know marketing for this firm. So anyone who happens to read the letter and see something they like, they can go to the website and contact me that way.

But, you know, running an investment firm, it's so important to have investors that are aligned with your way of thinking, your style of investing, and are, you know, partners for the long term. So I set it up in a way that there was a self-selection process where the investors that are coming on board agree with what I'm doing and agree with kind of the minimalism of the website and they can see what I'm looking for in investments and they can be self-selecting. No one's trying to be sold anything. I like the concept of minimalism because it gives also a lot of clarity and it also says that it gives a strong will to say no to many things. To what things are you saying no with spray capital and the way you approach investing? I say no to a lot of things. So I only have about 20 businesses in the portfolio, but do the research process. on many businesses and it you know it's really a high bar to make it into the portfolio so

i'm saying no to almost everything like what max what are the ingredients for you to to say no and say i'm not interested in this or or what you can also turn it around what makes you say yes that's probably an easier question to answer i when i think about investments that might have a role in the portfolio I look for really eight key things and you know I can get into those but first I look for repeatability in the business model so this can be a consumable product or service this can be some kind of business with dominant scale in a fragmented industry with a proven process for sourcing, acquiring, and integrating mom and pop type operators and putting

them on a common platform to, you know, have some kind of geographic expansion and densification. This can be a model-driven business with some kind of closed customer feedback loop where the business is able to monitor the way the customers use the product in a way that it creates data, which helps the business iterate and improve the product and add ancillary products, which drives a flywheel of more customers, more data, better products, more customers, and it perpetuates itself. And also as part of the repeatability in the business model, I'm looking for a culture that allows the business to adapt to change. And so that can mean some set of common principles or attributes that permeate through the organization.

And that is just so important because, you know, when different messages get handed off throughout different layers in the organization, it's like a game of telephone where the message changes throughout the whole process unless the culture is strong enough where the business operates all on the same playing field throughout the organization. It just helps them move faster, iterate faster, and create better products. So first is repeatability. Second, I look for predictability. And this comes out in a predictable path to value creation.

So no undue complexity. I'm comfortable with complexity. in certain business models that might be misunderstood, but the actual path to value creation has to be very simple and non-complex. And I think about that in terms of like the Nate Silver story about you can be a weather forecaster in Denver or Phoenix. Why not just predict the weather in Phoenix? It's 85 and sunny every day. I'm trying to be right.

I'm trying to generate high returns. I'm not trying to, you know, have some situation where A has to happen, then B has to happen, and C has to happen in that order. And, you know, at each iteration of that tree, there's a lower probability of the ultimate outcome happening. So I'm looking for simple, predictable paths to value creation. Three, I'm looking for growing end markets. The bottom line is that the pie has to be growing. I'm not looking for static end markets or shrinking end markets where there's a fixed pie and competitors are fighting for share and maybe making irrational decisions.

The size of the end market has to be growing. And ideally, that is from the company's own volition. So the company is creating that end market or at the very least growing it. And, you know, part of that is anytime you have a new market or a misunderstood market, there's almost always some kind of information asymmetry where, you know, businesses in new markets that aren't fully properly understood tend to trade a pretty attractive valuations. And you see that in Google IPO, Chicago Mercantile Exchange, MasterCard, Moody's, and so. of the businesses I have in the portfolio. And as part of the growing end markets, the industry structure itself has to be an industry where value creation is possible.

So that pretty quickly, going back to how I say no, that pretty quickly eliminates a lot of subsectors in energy, certain materials, subsectors, financials, you get the idea. Number four, I'm looking for increasing returns to scale. And the way I think about that is you have supply-side scale where the cost per unit declines as production grows provided there's no kind of input scarcity or undue bureaucracy in the business. And then demand side benefits to scale,

the combinatorial networks where, you know, like there's a network effect and each additional user makes the network stronger for everybody and each user is willing to pay more for that network. That is something that I'm much more interested in than supply side benefits of scale. But both of those are important to me because operating leverage is almost always mispriced. And this is because investors succumb to anchoring where they're biased by the past margin structure of the business, they're biased by linear thinking in terms of, you know, very few institutional investors are able to think in terms of step changes of a business model.

And then social proof, it's always better to succeed conventionally than risk failing unconventionally. In other words, no analyst is going to be rewarded for, you know, having it outside the box belief in their model and showing that to the fund manager and, you know, those three institutional imperatives tend to skew outcomes in our favor, and they're part of the reason why operating leverage and increasing returns to scale is almost always mispriced. And I think about those, you know, the path to operating leverage in terms of what costs are one time in terms of the starting up of the business and what will decline over time with scale. And so that's how I think about increasing returns of scale.

Then I look for a long runway of high return on invested capital opportunities. And that's so central and key to really any high quality business because most growth does not create value. that you know the return on invested capital has to be far in excess of the cost of capital so i like to see businesses that are self-funding that um you know growing in markets ties into this because if there's a growing end market and the business is self-funding those high return on invested capital opportunities are prevalent throughout that industry and when that business has a low penetration in a large growing addressable market, that is just such a great enabler of using internally generated free cash flows to reinvest in, you know, new product initiatives

and new niches that they are able to identify with, you know, back to what I mentioned before, the closed customer feedback loop, that all ties into feeding high return invested capital opportunities. And in terms of how I think about that, you know, technological adoption curves are great and they create a backdrop for growth, but you really have to kind of connect dots from different parts of the business and other businesses and other industries to think about how certain consumer trends might play out and, you know, think about different opportunities and products that might not even exist yet. So there's an innate aspect to quantifying some of those ROIC opportunities. Next, I look for a catalyst. I look for some kind of changing dynamic that

unfolds over a multi-year period. This can be technological, this can be managerial, this can be regulatory, but there's some kind of inflection point in the path to value creation for the customer base and for the business. Number eight, I look, or number seven, I look for a competitive advantage that must be growing. So this is the direction of the moat. It's not necessarily the size of the moat. And the way I think about that is that having a large moat is great for a business that doesn't change, but there are so many disruptive business models out there coming from every direction on every business out there. It's like going to the moat and castle analogy. You can have a great castle with a great moat, but if a new castle is built

right next door, they can starve the supply line of customers, and you don't even have to attack that moat. It's just rendered useless through disruption. and, you know, the old adage of competition is for losers, you want to differentiate. So for me, it's really about a growing competitive advantage, not necessarily the size of it. And, you know, as it's growing, I want to see a large one getting larger, but any kind of large one that's static is not meaningful for me. And then if all of those facets are satisfied, then I look at valuation. the way I think about it is, you know, a lot of people think about valuation in terms of this business as 10 times earnings or 10 times sales, but that really tells you nothing

about the valuation of the business. You know, all the numbers are in the past, all the values in the future. It only depends on the present value of future cash flows. And 10 times earnings or 10-time sales tells you absolutely nothing about what the earnings power of the business is in two to three years out. And investing based on the past is going to get you killed. So at a minimum, I'm looking at 18 months out into the future, and ideally two to three years or more because my holding period tends to be pretty long. And I look for a margin of safety, but not in the way that a lot of people think about the Graham and Dodd margin of safety where you go through the balance sheet and assign a liquidation or replication value for every line item of the

balance sheet. And that's how you come up with a margin of safety. For me, it's much more about the permanence of the business and how the growing competitive advantage translates into growing earnings power. And to get that, you need to have a deep understanding of the business, deep understanding of the paths of value creation to enable that ability to buy at a deep discount to the expected future value of those cash flows. And then, of course, unit economics and how those look, how the economics look on a per unit basis over a variety of, you know, a variety different playbooks and you know cack and lTV and all that stuff so that's kind of uh why i might say yes to an investment and you know if it doesn't satisfy those needs that's why i would say now

maybe let's try to zoom a bit out this this clear philosophy and this clear checkness of eight things needs a lot of work till you come to this point and needs also a lot of experience experience in the industry and investing. And what did you do before that has led you to this clarity and this concept? And what did you learn in these different stations you had already in your life? Because compared to the normal emerging manager, you seem to be a bit more senior. Sure. So I first started investing.

when I was pretty young. I had a paper route when I was in elementary school. And after a few years of doing that, I'd saved up a little bit of money. And I was close with my grandparents and noticed that they had their pillboxes with their daily prescriptions. So I put my life savings into Pfizer

because I liked that they made medicine that helped sick people. And around the same time, my parents started a college savings account for me and my dad had some domain knowledge in industrial distribution. So he invested in a company called air gas. So I had my Pfizer and then there was air gas and the dollar amounts were similar. You know, pretty modest investments in both. And fast forward until when I was off to ready to go to college and Pfizer had done okay, but the air gas was up, it was a multiple hundred bagger.

And it's actually a great case study for anyone who doesn't know that business, but they followed the kind of standard oil, Walmart, a couple other businesses, playbook of geographic expansion by buying regional anchors and then infilling through M&A, acquiring two to three businesses a month, because there was this large number of aging out World War II era mom and pop entrepreneurs that, you know, their kids didn't want to run these businesses. So they essentially rolled up industrial gas distribution and then later medical gas distribution. And, you know, fast forward to when I was going off to college, my Pfizer did okay. but this business did fantastic.

And so I was always intrigued by the fact that similar dollar amounts could have such drastic changes in outcome. And so that kind of was always percolating in the back of my mind. Went off to college, studied economics and psychology. And then professionally I cut my teeth at a firm called Gracie Capital. And Gracie had spun off from Gotham Capital, which was Joel Greenblatt's hedge fund. And we invested in the Greenblatt style of value

with the catalyst investing. So this could be spinoffs, demutualizations, you know, anything like that, any kind of change that was likely to be regulatory, managerial, or technological that created some kind of disruption in the path to value creation. and I was ultimately there for about eight years. It was a fantastic apprenticeship for me

in that I was able to be a sponge learning from some really great investors and, you know, taking a lot of what I learned and tweaking it in a way that is best suited for my personality. And, you know, I kept going back to these two investments that I made when I was very young and the drastic difference in outcomes where the typical hedge fund style

is you're grinding out returns there's a lot of turnover you know you're trying to get that high teen kegger but you're leaving a lot of good returns on the table by trying to come up with new ideas, new names all the time and if you think about the businesses that generate real returns And I'm not talking about high teen, you know, turning through businesses.

I'm talking about really the, you know, high caliber returns of 20% a year over 20, 30 years. You know, businesses like Amgen, Microsoft, HICO, Home Depot, Nike, Constellation Brands, Constellation Software, Adobe, Danahur. You know, the list goes on. There's not a lot of them, but that's really what I'm looking for. And the criteria that I went through, the eight things that I'm looking for is the business with a really long runway to generate very high returns over the long term. So at a certain point, you said, I have to invest for myself and have to found a structure where I can follow this passion. Is it that what drove you to make Spree Capital? That's correct.

I worked at some great places, but ultimately I felt like my process and my style was uniquely my own. And I had a very strong interest in starting a firm and growing a firm in growing a firm in in an investing style that I think really works over the long term and there was really no other option than for me to you know start with a blank slate and take all of my learnings and you know perfect my process and launch so that was January of 2019 I'm almost three years in now how did you go about it did you say I just cross a line and stop being at the hedge fund and now I go fully into

Spree Capital? Do you do it besides the job? What was your way of building the firm? So I took a few months in 2018 to get the firm up and running and you have to be registered and set up an LLC

stuff like that and take some time but the process and the systems that I'm using were just curated over my whole career. So nothing about my actual process was newly invented here. It's just, you know, sometimes when you're working for a fund and for a fund manager, you're, you know, you're hired gun, you're subject to other decision making that, you know, my full process

enables me to not be subjected to some of those institutional imperatives that don't always work best for long-term value creation. How have you built spray capital that it supports this pursuit for finding the high-quality business and it in itself is also a high-quality business for the different shareholders of it or stakeholders, maybe? sure so i set it up in a way that made it so i can spend 99% of my time researching businesses and managing the portfolio so what that means is you have to show this magic formula for the 99% That's a high rate.

Well, it's not, you know, it's not as hard as it sounds because I have an administrator that handles all the, all the, or I have a custodian that handles all the administrative tasks. So I don't have to deal with any of that. And then I do no marketing. So, you know, the idea that investors who believe in the vision and believe in the returns and the businesses that I'm investing in, self-select and find me, that just cuts out so much time and effort for, you know, going to conferences and doing stuff like that to try to raise money. I want investors that are long-term oriented and really believe in what I'm doing and

what's happening here. So, you know, that 99% is, you know, it's pretty easy to stick to. What kind of investors are you building Spree Capital for or let me turn it around a bit? What kind of investors have found you because you're building it this way? Sure. So at the start, it was friends and family and former colleagues, people that I knew and had relationships with that, you know, had... The only crazy ones who support someone who start something. Exactly. But people that, you know, knew some of my previous returns and, you know,

you know, had confidence enough to put their checkbook on the line. And then from then, it's been people that have, maybe someone was forwarded my letter by an existing investor and came on board that way. And I expect it to be that way, you know, certainly in the short to medium term where that just continues. Can you just close a bit to finally found you then over the years? Sure. So it's high net worth investors. Some family offices are trickling in and then endowments have been tracking me. And, you know, those decisions take a little bit longer. They want to

have conversations every quarter, but that's been ongoing with a handful. And, you know, look, I'm three years into something I'm going to do for 30 years. So I have no problem growing slowly and growing the right way. That's great to hear. You mentioned your previous returns before you started the firm. Can you maybe give a little bit of an idea how you managed your own money before that? So here's what I'll say. The returns at Spree have been, I've been compounding at about a 39% Kager over those three years.

prior to that, it was lower, but that's the whole point of launching your own firm is you can do things that aren't subject to interference that might disrupt returns. But the businesses that I'm looking for, you know, when I listed off the Microsoft Amgen, et cetera, the businesses that I'm looking for tend to compound at pretty attractive rates. Are there any investment mistakes when you look back in your investment career before you start a pre-capital that have learned you a lot? Yeah, you know, my hindsight book is compounded magnificently. So, you know, plenty of investments that I sold to early.

different businesses where, you know, being under the hedge fund umbrella, it's a different paradigm than what I'm doing here, where you, in that kind of institutional structure, you never want to have a down month, you never want to have a down quarter. and that really puts a tight leash on you for what you're able to own. And, I mean, certainly looking back at the financial crisis and how many businesses I was involved in that have gone on to generate spectacular returns, but, you know, everyone was worried about the Eurozone in 2011, so you couldn't, you couldn't, you couldn't, take risk in terms of owning some fantastic businesses like, you know,

name it, Apple, Microsoft, General Growth Properties. You know, there were so many things that went on to return 100X that you just weren't able to own in the aftermath of that crisis because there was just so much fear and you were optimizing for monthly returns. And to be clear, I'm, you know, I'm trying to generate very high returns over the long term. Of course, I care deeply about my monthly returns as well. And I'm, you know, not involved in trying not to be involved in any businesses that are going to blow up any specific month. But if I own a fantastic business that I think could go up 20x, 50x, 100x, I don't care much if it's down 10% in a month.

and, you know, I underperform the S&P by one or two percent that month. I'm optimizing for the long term. How are you taking this learnings into your process? Is there a certain feedback loop you installed or how you, is the feedback circle between learnings and mistakes and your process? Sure. So, you know, I'll talk about my, process. I think that's what you're getting to. So I think about my 20-odd-year investing

career and the experience offers a lot of benefits, but it can be, there can be baggage there as well. So when I, if I'm looking at a new business that is, you know, say it's, they just filed an S-1 and they're about to go public. So it's, so it's, it's, you know, pretty new to me. I try to have a completely blank slate when I look at that. It's about having a beginner's mind and a growth mindset where, you know, it goes back to the idea where, you know, once you're past 40, anything can be Elvis and you'd never want to be that person shaking your fist at Elvis. I just want to have a completely blank slate because, you know, having having a blank slate and really getting down to the core essence of what that business model is

and what they're doing and what they're trying to do and evaluating a product market fit, if that's a service that can satisfy a customer need. It's very easy to look at a new business and think it rhymes with something else that didn't work in the past and, you know, maybe it's a technology company that had a business model that was before its time, but then the next one, you know, this new business, this S1 I'm talking about, comes out and it's the right time. And, you know, to not let the baggage of your past skew your analytical perspective when you're looking at something new is very important.

And so I try to have that plank slate initially. And then I do all the standard things. I map out the value chain. I talk to customers. I talk to competitors. Try to get an understanding of the sustainability of the firm's cash flows. and if they can increase over time what the return on invested capital outlook looks like

and then I journey map a decision tree. So you think about like a binomial tree where there's two outcomes and then each node has two and it goes over four or five iterations and you have all these different outcomes. I'm looking for ideally three, or more things that work. There are reasons for me to own it.

So three or more shots on goal, where I can cut off the first few nodes, start at the four node process, and then think about how that business is going to unfold over time. And for me, that's helpful because it helps to map out some second and third derivatives of the trajectory of this business in terms of, you know, you have your four assets, four facets to the thesis and how those might unfold, but you really need to kind of think outside the box of different potential competitive threats and other things that might impact this path to value creation, and that helps me do that. you know it's you know like mike tyson says everyone has a plan until you get punched in the face

it's that's fine it's for me it's about you know having a plan is imperative so that you can adapt to those different scenarios ahead of time and anticipate them and you know plans are useless planning is everything that that's kind of how i go through those eight facets of what I look for in investments and how that translates into a process from a new investment. One thing that screamed at me a bit when reading for your materials is the definition or the high quality business. Are these eight aspects the essence of the definition of a high quality business for you? Yes, that's right. Those, all of those, the different facets of those eight aspects are all curated from long-term study of high-quality businesses that have compounded over a very long period of time.

So that, you know, when I read off that list, in my experience, a lot of the truly transformative returns on, very high quality businesses all share a few commonalities. And obviously they're all in different sectors and different business models, but they share a few common attributes that, in my view, are central to why they were able to create such value over such a long period of time. And so what I'm looking for in my investments is investments that will follow similar paths for similar reasons because they share attributes that aren't commonly understood or appreciated by other investors in the market. So you have this high quality filter, but you only have 50 to 20 positions. How do you select between high and higher quality in the way you build your portfolio and

say, this is a high quality business, but currently it's not part of my portfolio? What are the selection criteria? Sure. So I have, I try to have 15 to 20 businesses in the portfolio. And then I have pretty large watch lists for businesses that fit some of the attributes I'm looking for, but not all of them. Sometimes that can be valuation. Sometimes that can be something else. There's one thing missing in their business model that precludes it from being included in the portfolio.

But in terms of how I think about building up the portfolio, you know, obviously position sizing is a function of risk reward where the largest positions should be the ones where you can lose the least. But there are nuances to that in terms of, you know, sometimes a business might be particularly misunderstood in the market. and the KPIs are trading well, the stock's trading well, which, you know, I don't care much about momentum, but I think that's something that is not appreciated because, you know, you'd be crazy to have a large position in something that is completely out of tune with the market. Ideally, you can enter that when that misunderstanding is starting to change. But, you know, all that shapes out to, I try to have no more than a, at initiation of a position,

I try to have it be no more than 10%. And that shakes out to, I think I have three positions at about just below 10%, 7% to 5%, and then the balance is in the kind of 3% to 5% positions. So, you know, three at ten, seven to five, and then the remaining five to ten positions are somewhere between two or three to five. And that is what works best for me. You know, it translates loosely into the kind of, you know, what is it, the 1040 model loosely to loosely to that, but, you know, sometimes. you have a 10% position at initiation that significantly outperforms the rest of the portfolio. And, you know, I'm not looking to have one thing be 20%. It's just too much risk for me to handle.

You know, that's why I have a basket of these high quality businesses because different things to work at different times. Why not boil it down more to just maybe 10 positions? I haven't had a problem finding the 15 to 20 businesses that I really see a great path to value creation in. If I had 10 positions that were each 10%, you know, there's a different level of risk there. And sometimes things work for different reasons. different times. And, you know, I'm not trying to optimize for weekly or monthly returns. It's all about the long term, but, you know, it's still not fun to underperform in any given

month. And as long as I can find 15 to 20 businesses that I think are going to grow at 20% or more per year, I think it's a pretty good way to mess. I put the portfolio. One sentence I've read on your website is we believe that qualitative analysis unearths the most asymmetric mispricing opportunities. How important is this qualitative analysis for you and how you're doing it? What are factors that are important in this analysis? I think that's where value is created.

So obviously everyone knows the number. And, but, you know, I guess that kind of comes down to, let me answer that in a different way. So the way that information is disseminated to the market is, you know, rapid and in real time. and anything related to the financials are backward looking and anything related to trailing valuation is backward looking and the only way to really generate outsized returns in my view is having a deep understanding of the business that comes through all the qualitative work and that is why, you know, like you were asking about the things I look for in investment, valuation is number eight and that's performed last because without all

of that work, any kind of thinking about valuation is meaningless because, you know, a P.E. number tells you absolutely nothing about return on invested capital, what the balance she looks like. There's so many things that are so important that the commonly used valuation numbers that people mention on a trailing basis are completely useless. So I think 90% of the value added and generating real outsized returns is the qualitative work. So how are you going about the qualitative work? What are important methods for you? How are you approaching companies? Is it you looking mostly at culture? Be happy to hear your answer on this. The business model is the most important thing for me.

So it has to be a business in an industry where value creation is possible. And in terms of how I assess that, it's a lot of talking to customers, competitors, understanding the customer value proposition and the paths of future value creation of the RIC and the RIC of the RIC and earning stream in the future. And, you know, it's a lot, of course, reading all the filings, reading industry magazines, finding people on LinkedIn, you know, doing real grassroots level research to fill in any holes I might have in assessing the quality of the business. and it's you know there's no there's no simple answer it's a long process and it involves a lot of

different touch points and you know you try to really get a deep understanding of the two or three things that really matter for this business and obviously from those two or three things there's a web of you know 20 odd things that um that matter for how those two or three things will unfold and tracking those 20 things is deeply important. But in anything I invest in, I want to have two or three simple things that I can explain to a 10-year-old and not have to resort to some complicated financial model. That is a part of it, but that's never a part of the thesis. that is just, you know, helpful to iterate and understand how different factors and

KPI translate to earnings and so on. But I'm, you know, ultimately looking for a few simple things for why all of my businesses are going to compound value over the long term. How long does it usually take to build this qualitative confidence for you? You know, no less than call it two to three months for a new business, but sometimes it's much longer. You know, I have a lot of businesses on my watch lists that I've been tracking for years and years. And there's always been one or two things missing that have kept me away. but the goal there is that they're always in the on-deck circle

where when something changes I'm able to tap that business into the portfolio quickly so it's you know it's a lot of work and a little bit of action when everything tees up appropriately you said we want to talk about ebay and upwork in this talk maybe you can explain the two to three things that matter for you in both cases that we have some examples for these two to three things sure so you know that's a good that's a good example because so upwork went public in the fall of 2018 and it was you know into a pretty weak market and you know I always love when new businesses come out when the market's trading and they're not, you don't get some crazy pop.

I had some time to study it. So I studied that for, you know, it was a while, a year plus. And I'll just explain what Upwork is a little bit, but it's an employment marketplace that connects on-demand workers on the supply side and businesses with hiring needs on the demand side. And the value proposition is that it's a centralized, trusted counterparty for each side of the marketplace. On-demand workers benefit from having quality work and timely compensation, and then a reputation ranking system where they're able to use that reputation ranking to feed their customer acquisition funnel.

And then businesses benefit because they're able to have access to, specialized talent that enables them to hire faster, more cost effectively, and gives them the strategic optionality to flex a portion of their workforce based on changing demand requirements. Market size is, it's a very large market, depending on who you ask, but it's somewhere between $500 billion and $5 trillion based on, you know, based on whether you're trusting McKinsey or different competitor decks and so on. But the bottom line is Upwork has a gross services value of $4 billion. And, you know, their market share is tiny compared to the size of this massive market.

And if you think about just the U.S. in Europe, there's $100,000. 50 million on-demand workers, but only about 5% are using digital platforms to source work and execute work. So UpWorks business today is 80% small and medium-sized businesses, mostly cross-border, mostly IT, but they're building long-term S-curves in different non-it verticals to execute a proven path to value creation that comes with spurring offline to online conversion. You see that in many other businesses that have done similar things in slightly different ways. And you think about the barrier to this on-demand work being done digitally, it's really

ingrained habits on the demand side. So businesses prior to COVID it was the pushback was businesses didn't want to hire people that weren't in their main offices and they thought there was some risk element there. But all

throughout the last 10 years you've had this great asset value creation in collaboration software and cloud computing. And then you had COVID where everyone became a remote worker. So the structural barriers are collapsing rapidly, you know, that have prevented mass adoption of a platform like Upwork. So, you know, as I said before, anytime I look for an investment,

I'm looking for multiple ways to win. In Upwork, I see a handful, but for this, I see two main reasons why Upwork is going to help push down some of those structural barriers to adoption. So first, Upwork is modularizing the most common jobs served on the platform. They are doing this to reduce frictional barriers to adoption on the demand side. And this is being executed through something called Project Catalog. This is a collection of quality verified, predetermined, standardized projects which businesses can purchase in an easy, clickable e-commerce type user experience. This acts as a great discovery engine that widens the customer acquisition funnel in that businesses are able to come on with this simplified, consistent customer experience.

experience and take bite size portions to then scale across the platform and some of these other S curves that Upwork is building. And, you know, as I've seen in so many other businesses, having a standardized, simplified, guaranteed high quality process for a product is, you know, transformational in terms of of how it changes customer habits and creates new markets. And you see this in everything from McDonald's to Amazon. The process of commoditizing supply while aggregating demand breaks down barriers to adoption for this business.

And as we've seen with IAC interactive, powering offline to online conversion is a tremendous value creation mechanism. And there are a dozen business. businesses that all have done fantastically well by, you know, commoditizing that supply and pushing forward this offline to online conversion. And think about the labor market. There are so many unnecessary frictional inefficiencies in the labor market. There's regional talent imbalances.

There's a talent shortage depending on where you are. businesses have a hard time finding very specific needs for what they're looking for in their workers. But the structural backdrop to this is changing. And I love that this helps spur forward economic mobility because it really shouldn't, you know, if someone has a strong drive and desire to build a marketable skill for themselves, and they should be able to sell that skill to a business, and they shouldn't have to live in New York or San Francisco to do that, and Upwork really enables that on a global scale. Second, I like that Upwork is evolving to become an enterprise resource planning system. So as a labor market,

place. There's a transactional element. It is a subscription model as well, but it's mainly viewed as a transactional business. But Upwork is building an operating system for businesses to manage their workforce, both distributed and localized. And expanding these workflow software as a service tools help to make Upwork a platform, not a transactional business. There are three parts to this. One is Upwork is rolling out employer of record status that indemnifies businesses on the demand side from misclassification risk. And that's pretty meaningful because it creates a position where if you're a hiring manager, you don't get fired for choosing upwork. You're not at risk for punitive fines and back taxes. And that's very

meaningful for pulling that demand side onto the platform. Next, they are expanding the payrolling solution, which is a centralized escrow protection that, um, enables businesses to only pay for completed work and importantly on-demand workers only on-demand workers get paid on time and in full and that's significant because if you ask an on-demand worker their biggest complaint is that they're not getting paid on time a lot of businesses choose to treat on-demand workers like their vendors so they're squeezing working capital to push off payment and having being a centralized counterparty that protects the business businesses on the demand side and on demand workers on the supply

side from any issues in payment is is meaningful being having a position in the middle of the payment flow is able to pull users onto the marketplace and upwork provides that distribution relationship where they bring value to both parties. And part of pulling the supply side onto the platform is something called direct contracts offering. So now I'm seeing a lot of on-demand workers taking their work relationships that they don't have through Upwork onto the Upwork platform because the simplified billing is beneficial to the on-demand workers.

So they're choosing to pay a take rate on that in exchange for getting paid on time and in full. And besides those two things, Upwork is expanding analytics and reporting functionality for different productivity, compliance, and risk controls aspects that has other impacts in terms of how it further ingrains businesses into the operating system, you know, from. a transactional previous history. And, you know, having this workflow SaaS business with payroll, escrow, and then tools for hiring managers, tax reporting, compliance really creates this great flywheel where it's a category leading two-sided marketplace. They have superior liquidity on both sides of the platform. And as that grows, the gap versus competitors grow.

It just builds and builds and builds. And you're getting all of this at a valuation that does not give proper credit to the fact that this business can grow for 20% per year for many, many years. You know, it's an 80% recurring revenue business from core clients. You know, you get in a business that is 80% small, medium, sized businesses, you get natural churn, and that's not really a concern. Their recurring revenue is actually much stronger in enterprise clients. And, you know, one of your guests spoke about cognitive reference, which is also something that I love in my businesses. Upwork has 73% direct to the website traffic without search. And over time, as they build this B2B domain,

in-gen generation product that's less about, you know, search engine optimization, that becomes more of a landing page where you land on the upward page, you click to sign up, you enter your credit card information, and you're done, and you're, you can build your virtual talent bench to, you know, flex your workforce based on your changing needs. This flywheel just grows and grows and grows. And, you know, in terms of the valuation, I said it's undervalued based on this, you know, how long I think this can continue at a 20% growth rate. Right now, it's a 73% gross margin business that it's going to scale to 85, R&D, sales and marketing, G&A, all of which are, you know, they won't quite be cut in half at scale, but there's very meaningful

earnings accretion for those aspects of the cost structure that are going to unfold over time. And, you know, there's no reason why this can be a many backer over time as this, as you get this kind of zero to 10% GSV per client growth clients growing at 10 to 20% a year all that translates into 20% GSV growth 20% revenue growth

and all of this scales very attractively you know and I spoke about increasing returns to scale that's very evident here and not that this is my reason for owning it, but this is also a highly strategic asset

for a large number of software vendors in the HR and small and medium business space. Thank you for this great insight into your Updug thesis. When you think about Upwork, you had to also think about Fiverr, which is a competitor in doing, similar things. Why did you go for Upwork instead of Fiverr? Hey, Tillman here. I'm sure you're curious about the answer to this question, but this answer is exclusive to the members of my

community Good Investing Plus. Good Investing Plus is a place where we help each other to get better as investor day by day. If you are an ambitious, long-term-oriented investor that likes to share, please apply for Good Investing Plus. Just go to Good, minus. is investing.net slash plus. You can also find this link into show notes. I'm waiting for your application. And without further ado, let's go back to the conversation. What importance does the management play

when you're investing in Upwork and other companies? Is it in your focus of the research or how do you value the management? it's definitely very important and you know everyone everyone says the same thing on management you want a high quality management team with character and integrity that has a history of creating value at other businesses they have a history of doing the processes to create value in this business of course all of those things are very important to me I also factor in the opportunity of the business and, you know, the pathway for value creation, and that's very important, too.

I would never invest in a business with questionable management with questionable ethics and character, and, you know, that's just a non-starter for me. management of upwork, Hayden Brown, comes from a product background. She's a very capable, you know, very strong manager. You know, I like to have owner operators or entrepreneurs. She's not that, but I really like the product background that she came from. And, you know, I think she's doing great things with this business and we'll continue to going forward. zooming out to your portfolio would it be okay for you out of the diversification thinking to own two investments in the space so it's like you say fiber gets cheaper and you say oh fiber also looks interesting about i own them both or is it that you say i focus on certain industries and just want to pick one winner in it i would not own fiverr as well

the way I think about it is I want each of my businesses to have a growing end market that is uncorrelated with the rest of the portfolio. So, you know, it doesn't mean I can't own several businesses that are in the technology or communication sector, but I want the actual end market that drives the factors in the end market driving growth of the end market to be uncorrelated with other businesses in the portfolio. And, you know, obviously, I've seen it over the last two, three years, you have some of these factor beta unwinds where you get a rate back up and, you know, anything remotely related to communications,

tech gets hammered, but I'm concerned about the actual path of the business. So I'm willing to wear a little P&L, you know, as the machines move stuff around, even though it's not related to the business. It's the correlation of the end market, which matters for value creation. And that is what, you know, enables me to have the stomach and intestinal fortitude to hold these fantastic businesses. You know, if you're smart or lucky enough to find a five, ten, a hundred bagger, you, it's really important to have that whole discipline. You know, everyone wants to know about what's your sell discipline, but whole discipline for a fantastic business is extremely important. And you get that by understanding the key drivers of the business and the key drivers of the end market. And having a portfolio of businesses with uncorrelated end markets is very helpful in, you know, when, you know, like today,

yesterday, the 10-year going up, you know, 10 bips over two days or whatever, is going to cause some stocks to get hit, but that's a short-term issue. It's, you know, the businesses I'm owning are not levered. Rates aren't a factor in them. They're sometimes pressured by, you know, transitory spikes, but the path to value creation in the actual business that is reinforced by those uncorrelated end markets is completely unaffected. And that's what is important for, you know, owning these names and compounding portfolio returns at a high clip. No actual business risk.

So the key to your whole discipline is just deep understanding or do you have any other keys to the whole discipline? A deep understanding of the business and the path to value creation. and, you know, that creates the impetus for really attractive opportunities when you get some of these factor beta unwinds where, you know, certain names could sell off for 10% in a month for, you know, no real reason besides, you know, what different names in the sector are doing. And, you know, there's just so much money in the market now in these, you know, very large quant strategies that it creates really attractive opportunities for long-term businesses, you know, several times a year. And you just have to have that deep understanding and do the work ahead of time. So, you know, every once in a while you get really attractive opportunities. And that was the case for Upwork for me.

You know, it was a pretty quick double from when I bought it. And, you know, it's come down a little bit in the last couple months. They used you to convert and, you know, that's part of it. But, you know, there are so many fantastic businesses that are unduly pressured by factor beta trends that, you know, you just have to kind of prepare and be ready for it because opportunity favors a prepared mind. So what is your reason to sell then? Is it that your holdings don't execute against the two or three things you consider it as important? Or what drives you to sell a position then?

I sell when the thesis breaks. So I have my reasons for owning it and I have my. journey map binomial tree of different scenarios and if the path to value creation is taking an alternate route whether you know change in management change in competitive environment anything that impacts what this business is going to look like you know over my expected holding period that would cause me to sell you know I think a lot of people say they never sell based on valuation. I don't know if I'd go that far because sometimes things get particularly skewed in terms of their valuation, but that tends to not be a reason for me to

sell, you know, depending on the situation, of course. But it's always about the thesis breaking because I'm I you know 15 to 20 names in the portfolio and that forces me to rank the path to value creation in in the various businesses so for me to add a new you know 5% position in the portfolio that typically means something else has to get kicked out and if the expected return in something new is significantly better than something I've had for a while that, you know, has had the thesis break in some way, then it's a pretty easy decision. But my holding period tends to be pretty long, you know, kind of two plus years at a minimum. So it's a very tax-efficient strategy. And then, you know, it related to that

if the thesis breaks and there is negative P&L on a, I always try to realize those tax losses. But it's it's the thesis breaking and a better opportunity come along. You have one position in your portfolio also want to discuss. It's eBay and eBay fascinated me a bit because like if you go through the write-ups, you posted it's catalytic, Pinterest, Wix.com, match, and Roku data, all this kind of fancy businesses. And then there's one holding you already have a while. That's the good old eBay. How does it fit in the thinking about your business?

portfolio, how does it, thinking about correlation with other positions? What's the, what was or what is the idea behind eBay? Sure. So I took a position in eBay in early January of 2019 for around 30 bucks. And the consensus at the time was that eBay was being disrupted by Amazon and there was just this intense focus on the gross merchandising volume of the business. And I actually thought that eBay was a fantastic business that was embarking on a few self-help initiatives that could grow sales and grow margins. You know, the core marketplace business at eBay is asset light, it prints free cash flow. it's, you know, it's just a fantastic business, you know, despite the consensus at the time that it was being disrupted by Amazon and so on and so forth. There were three parts of my thesis.

One was that eBay was moving payment processing from PayPal after the termination of that contract in 2020. So that was a year and a half ahead from when I bought this. And, shifting that payment processing from PayPal, positioned eBay to earn the spread on gross merchandising volume of $100 billion. So PayPal took about 4%. I thought that even if eBay only took 3.5% their marketplace revenues were like $8.6 billion at the time. So, you know, $3.5 billion on $8.6 and of high margin. revenue coming in the door, pretty meaningful. And it would also lower the take rate and, you know,

improve the value proposition for sellers in the eBay ecosystem. Second, I thought that eBay was in the early stages of allowing promoted listings on the marketplace. And in similar businesses, promoted listings generates, you know, somewhere between two to 3% in advertising revenue, 2 to 3% of the GMV. And there's an argument that it could be much higher, but just based on other businesses, call it 2% to 3%.

So that's another $2 to $3 billion of high margin revenue coming in the door as they started to embark on this low-hanging fruit, no-brainer value proposition, path to value creation. Third, I thought there was substantial hidden asset value within eBay. eBay had Stubhub and International Classifieds. They were both operated autonomously. They were high margin, they are high margin businesses that grow at a double-digit rate. And then additionally, they had a warrants for a 5% stake in Agin, which is a fantastic business as well.

that was as part of an agreement they made, you know, once the agreement with PayPal was expiring in 2020. So because of those hidden asset value in StubHub classified and then later Adyen, I was buying the core marketplace business of eBay from, you know, depending on what my assumptions were for those three assets that I mentioned. somewhere between three to five times IPADA for eBay marketplace. And, you know, I'm not talking about some like super levered TIO2 cyclical business. I'm talking about a fantastic high free cash flow business in eBay that in no world should that trade it three times EBDA. And I, you know, should say that I'm not a believer in some of the part valuation methods. that's been value-trappish for me, but it was clear to me that the management of eBay

was very open to monetizing these assets. And I had a high enough confidence level in the first two parts of my thesis where even if I was wrong about the willingness of management to monetize these assets, I thought I could still generate kind of my 20% IRR bogey at in this business. I had three shots on goal, and I felt, you know, very good about really all three of them, but all of them didn't need to work. That was my thought process in 2019. A market cap of 27 billion, enterprise value of 32 billion, and they had about 950 million shares. Since then, they sold Stubhub for 4 billion, turned those proceeds to repurchase shares. He sold the classic

business to out of Vinta for $9 billion, $2.5 billion of which was cash, and then the rest was in shares. As part of the shares that they received, those went on to skyrocket. So that $9 billion was really like $13 billion plus. And then recently this year, they sold an 80% stake in the Korean business for $3 billion. That wasn't part of my initial thesis, but it helped. you know, all told you're talking about $20 billion in asset sales on a market cap at my purchase price of $27 billion. So, you know, fast forward to today, market cap is $48 billion, enterprise value is $40 billion. They've repurchased about 30% of the shares, and then they've done a couple other things in terms of they're implementing a guarantee program. for, you know, helping ease some frictional barriers to adoption

and product verticals like, you know, expensive handbags, watches, and so on. And then they're doing a tech-led kind of reimagination of search engine optimization and price matching of the business. And one great thing about the scale of eBay is they, you know, there are so many, niche collectible businesses that transact on this platform and they can design this authenticity guarantee program in watches and then roll it out to you know dozens of other similar verticals that you know there's no incremental cost or minimal incremental costs to doing that and they just have the scale where you have you know you have you know

all these repeat customers that are rediscovering this platform and, you know, it's just a fantastic business. Now, I just, you know, I was right about the three parts of my thesis, but this stock kind of did nothing in 2019. Same in 2020. It's done well this year, but for most of the time I've held it. It was a drag on performance for the portfolio. So it was one of, you know, one of my least successful investments, but it had a valuable role in that it, you know, it lowered the duration of the portfolio a bit, which some of the value with the catalyst names tends to do. And that helps create ballast to the portfolio. Any time you get those like factor beta spikes that I mentioned before. So in addition to having a 20-ish IRR, it had an attractive risk mitigation role

in the portfolio as well. And obviously now looking forward, it's, you know, they're about halfway through of the first two parts of my thesis and complete on the last part of my thesis. So I'd say the, you know, for me, the low-hanging fruit in this path of value creation has been picked, but I still think it's a fantastic business that, you know, can grow over time with some of these initiatives. And, you know, they're a share cannibal and, you know, they have a dividend that wasn't there before. So it's, you know, it's still a pretty high-quality business. But how does it fit to your eight key criteria for the high quality businesses? Because I think I haven't written down all the details of these definitions, but they assume

a certain way of growing, growing end markets, this long run way of reinvestment opportunities and the competitive advantage that's growing. So how does eBay fit in this framework? Well, there's definitely repeatability in the business model. It's a, the path to value creation was very predictable. You know, there were those three simple things that were happening and ultimately did. Growing in markets, e-commerce is definitely growing so that, you know, it checks that box. Increasing returns to scale.

That's true for how they're implementing some of these, you know, authenticity guarantees. and other initiatives across their product set and portfolio. It's, you know, the way I mentioned that increasing returns of scale in Upwork is a little different because there's a major margin inflection as the, you know, scalable demand growth layers on top of that low fixed cost structure. So increasing returns of scale are definitely evident. at eBay, just in a slightly different manner than what I talked about in Upwork. Long runway of high ROIC opportunities, very prevalent at eBay.

Catalyst had the asset monetization. Buybacks also then for you this RRIC opportunities, or is it building the business? It tends to be more building the business. I mean, in a business that's a little more mature like eBay, they can definitely, you know, buying back a lot of shares is a good path to creating a lot of value. But I would, in other businesses in the portfolio, I much prefer to see organic areas to grow where they're able to use that internally generated free cash flow to reinvest in different ROIC opportunities. opportunities. But, you know, eBay does have a fair number of ROIC opportunities that they can use their free cash flow on. It's just the growth at the end market here is just not as significant as, you know, some of the other businesses in the portfolio. Catalyst was, you know,

very clearly there. Competitive advantage that must be growing, you know, In my view, eBay is a fantastic business that maybe could have been managed a little bit better. And some of the things that the current management team is doing now very much are working to grow that competitive advantage. So that it checks out box. And then valuation, like I said, I was buying the core marketplace business at, three times you but da which is even less after they some of these initiatives are done thank you very much for this great insights your process and the way you approach investing and the two stocks for the end of our interview do you have a point to add we haven't discussed

could also be two points you want to mention that are interesting for the years nothing jumps out you know you're a good interview for the end of our interview i want to ask one last question for the composition of your portfolio it has a certain tendency to be focused on american businesses um is it the the market you're mostly looking at or how do you see or do you find yourself as a global investor is finding the best opportunities communities and U.S. markets? It's what I know best. And, you know, usually there's a pretty high bar for me to invest in something overseas that, you know, I have to know the business and understand the path of value creation very well, you know, in the same way that I do for anything that goes in the business.

portfolio, and that's harder sometimes when, you know, I'm not there. And, you know, certain countries, an American investor can be the last to know. And, you know, but I will say that some of the businesses I'm investing in have global scale in terms of their business model. You know, like I have something like Stone that's very clearly Brazil and, you know, other parts of Latin America probably in the future. But it's very much a Brazilian investment. But then something like Wix is a global investment listed in the U.S. based in Israel. So, you know, that's that's a U.S. business, but it's really a global business. and, you know, Upwork is very much a global business as well.

So it just has to be something that I'm not going to be among the later people to know about. And that tends to happen in a lot of EM markets. And, you know, I'm not looking to be a tourist somewhere. I'm looking to have some kind of deep edge that comes from, for my analytical ability to understand the business and, you know, understand the path to value creation. Thank you very much for the great insights and at the time you spent with me doing this interview. Well, thank you.

Thank you, Tom. And thank you for listening to the audience. See you soon at the next episode. Bye. Hi. As in every video, also here is the disclaimer. You can find a link to the disclaimer below in the show notes. The disclaimer says, always do your own work. What we're doing here is no recommendation and no advice.

So please always do your own work. Thank you very much.